Essay: The lower of cost or market rule requires a company to value its inventory

The lower of cost or market rule requires a company to value its inventory at the lower of the cost of the inventory and the market (replacement) cost of the inventory. This is an example of the conservative nature of accounting. Accountants want to be sure inventory is not overstated. The LCM rule has gained wide acceptance because it reports inventory on the balance sheet at amounts that are consistent with future economic benefits.

 

One of the components sold by an electronics firm has become economically obsolete. A particular style of suit sold by a retailer is outdated and can no longer be sold at regular price. In each of the instances, it is likely that the retailer will have to sell the merchandise for less than normal selling price. In these situations, a departure from the cost basis of accounting may be necessary because the market value of the inventory may be less than its cost to the company. The departure is called the lower of cost or market (LCM) rule. The term “market” in the LCM rule means the cost to replace the item by purchase or reproduction. The market amount is limited by ceiling and floor restrictions that are based on measurements of exit value.

(1) The ceiling is equal to net realizable value: estimated selling price less estimated disposal cost.

(2) The floor is equal to the ceiling less normal profit margin.

When the lower of cost or market rule comes into play, it can be an indication of how bad things are for a company. For example, through poor management, a downturn in the economy, and under performing stores, Kmart found itself with a huge amount of excess merchandise. The company had to mark down its inventory by $1 billion in order to sell it, which resulted in a debilitating loss.

Paste your eLower of cost or market calculations shall be conducted at least annually for the entire inventory. The following chart gives four separate examples of the application of the LCM rule; the resulting LCM amount is highlighted in each case.

Market

Item Number of items in inventory Original Cost (LIFO, FIFO, etc.) Replacement Cost Net realizable Value Net realizable value minus normal profit

A

B

C

D 10

8

30

20 $ 17

21

26

19 $ 16

18

21

16 $ 15

23

31

34 $ 10

16

22

25

The LCM rule can be applied in one of the three ways (1) by computing cost and market figures for each item in inventory and using the lower of the two amounts in each case, (2) by computing cost and market figures for the total inventory and then applying the LCM rule to that total, or (3) by applying the LCM rule to categories of inventory.

To explain, we will use the above data to show how the LCM rule would be applied to each inventory items separately and to total inventory.

Item Number of items in Inventory Original Cost Market value LCM for Individual Items

A

B

C

D 10

8

30

20 $ 17 X 10 units= $ 170

$ 21 X 8 units= 168

$ 26 X 30 units= 780

$ 19 X 20 units= 380

$1,498 $ 15 X 10 units= $ 150

$ 18 X 8 units= 144

$ 22 X 30 units= 660

$ 25 X 20 units= 500

$ 1,454 $ 150

144

660

500

Using the first method, applying the LCM rule to individual items, inventory is valued at $1,334, a write down of $164 ($1334-$1498) from the original cost. With the second method, using total inventory, the lower total cost ($1,498) or total market value ($1,454) is used for a write down of $44. The write-down is smaller when total inventory is used because the increase in market value of $120 in item D offsets decreases in items A, B and C.

The journal entry to write down the inventory to the lower of cost or market applying the LCM rule to individual items is:

Loss on write down of inventory (Expense) …………………………………. 164

Inventory…………………………………………………………………………….. 164